What Is A Mutual Fund?
Mutual funds are a basket of stocks grouped by a common theme. For example, a tech-oriented mutual fund will have a variety of tech-based stocks in it.
A bond fund will be made up of different bonds. There are many types of mutual funds to choose from depending on what you are looking for.
Investors purchase shares of a mutual fund, which creates a pool of money for the fund to invest. Fund managers use this pool of money to purchase stocks for the fund.
Any returns on purchased stocks are sent to investors through the fund. This can be in the form of capitals gains and dividends.
Not all mutual funds contain stocks that have a common theme. Some try to mimic the broad stock market.
This can mean the mutual fund contains many funds that have no relation to one another and are well diversified.
Some mutual funds are highly leveraged. These funds are called 2X or 3X. For example, an S&P 500 2X Bull fund attempts to return two times the S&P 500 performance. A 2X Bear does the opposite. It goes up two times the amount the S&P 500 goes down.
Leveraged funds carry more risk than non leveraged funds since they can also decrease in value much quicker than the equivalent non leveraged fund.
Let’s now look at the pros and cons of owning mutual funds.
Mutual Fund Pros
Mutual funds are managed by investment professionals. People who have more experience than you or I. These fund managers also have the full resources of the parent mutual fund company at their disposal.
There are two types of managed funds - active and passive. Actively managed funds use a unique strategy to generate returns. Passively managed funds, sometimes called index funds, simply try to replicate the index they’re tracking.
Vanguard is the largest passively managed fund company, as shown below.
Jack Bogle, the father of index investing and founder of Vanguard, had this to say about active vs. passively managed funds, “The active managers have a philosophy they can win.
They come into the office every day and say, “Boy, Mark, I’m going to beat the heck out of you today," and they don't.
When they have a bad year, they say it’s that year; I’ll do it next year. It’s a hard business and it’s not the expense ratios that have to be cut, but also the trading. The transaction costs are very high – they’re hidden; they’re not going to tell you what they are – they are there and they are large.”
Mutual funds are also well diversified. Because many stocks are purchased and not just one, the risk is spread across a basket of stocks. The more diverse a fund, the less risk it carries.
For example, a tech fund carries more risk than a broad market fund. But a tech fund is less risky than holding a single tech stock.
Liquidity isn’t a problem with mutual funds in most cases. When an order to sell shares is entered, your shares will be liquidated at the end of the day. The only time there may be a problem with liquidity is during a major financial event, such as the financial crisis of 2008/2009.
Mutual Fund Cons
Fees can be high on actively managed funds. A 2% annual fee is not uncommon. The annual fee is composed of components such as front-end (charged at time of purchase) or back-end load (charged upon sell) and 12B-1 (market fee bundled into overall fee).
While actively managed funds have high fees, keep in mind that passively managed funds can have fees as low a 0.08%. That’s only $8 on every $10,000 invested.
Mutual funds can’t be opened or closed during the trading day. You have to wait until the end of the day to get into or out of a fund.
Tax inefficiencies also have to be taken into consideration. Some funds will distribute capital gains during each year. You’ll need to pay taxes on any capital gains. Other funds might defer capital gains into later years, creating a larger distribution and much higher tax bill for you.
There has been a broad movement in recent years away from actively managed mutual funds to passively managed or index funds. Mainly because of their performance and lower management fees.
Passively managed funds are also more tax-efficient since they do not trade as much as actively managed funds.
Which ever type of fund you decide to choose, you’ll now be armed with information about their pros and cons, allowing you to make a more informed decision.
Do you invest in mutual funds? Why or why not?
Robert Farrington is America’s Millennial Money Expert® and America’s Student Loan Debt Expert™, and the founder of The College Investor, a personal finance site dedicated to helping millennials escape student loan debt to start investing and building wealth for the future. You can learn more about him here.
He regularly writes about investing, student loan debt, and general personal finance topics geared towards anyone wanting to earn more, get out of debt, and start building wealth for the future.
He has been quoted in major publications including the New York Times, Washington Post, Fox, ABC, NBC, and more. He is also a regular contributor to Forbes.